Your Very First Options Trade

When I teach options seminars, I often ask how many participants are brand-new to options. Almost always, about half to three-quarters have never traded an option before. This tells me that investors are interested in options, but perhaps, they don't know where to start. This article provides a step-by-step guide to help you:

• Set up your first options trade—a covered call
• Possibly sell a very small stock position at a favorable price

An option is a contract giving the owner the right, but not the obligation (hence "option"), to buy or sell a stock, exchange-traded fund (ETF) or other security at a set price (called the strike price) within a specified period of time.

When trading options for the first time, investors sometimes select long call options. This gives you the right to buy a specified stock (or other security) at any time until the contact expires. However, the results are often disappointing because both time and price can work against you.

Instead, I recommend considering a covered call for your first options trade. 

A covered call is when you sell someone else the right to purchase a stock that you already own (hence "covered"), at a specified price (strike price), by a certain date (expiration date). When it's structured properly, both time and price can work in your favor.

Additionally, a covered call is generally considered a relatively low-risk strategy, and approval to trade covered calls can usually be granted to investors that have never traded options before.

How do you get started? After your Schwab account is approved for options trading, follow the steps below.

Select a stock position in your account with the following criteria:

• You hold at least 100 shares
• The stock trades at a higher price now than the original purchase price
• The stock does not pay dividends (or pays very small dividends, or you're not counting on receiving dividends)
• You would be willing to sell the stock at the strike price at any time through the expiration date.

You can sell one covered call for every 100 shares of the stock you own. In our example below, we'll be assuming that you sold only one covered call.

Once you've selected your position, you'll need to determine a price at which you would be willing to sell just 100 shares of your stock anytime within the next 30 to 60 days. In making this decision, analyze a one-year price chart.

For example, assume it's March 8, 2021 and you've chosen stock XYZ. You only want to sell 100 shares if the stock's price gets back near its peak. As you can see in the price chart below:

• The current price of XYZ is $79.01.
• The stock has traded within about a 20-point price range over the past 12 months.
• The highest price that XYZ has reached over this time was around $84.00 several times last year.

You may be able to sell one covered call option on XYZ with a strike price near $84.00 and an expiration date 30 to 60 days from now. To determine if this is feasible, you'll need to find available strike prices using an order entry tool on one of our trading platforms, such as StreetSmart Central, or in this example, StreetSmart Edge^®. You can also use Schwab.com. 

1. Open StreetSmart Edge.

2. Click Launch Tools.

3. Select All in One Trade Tool.

4. Navigate to the upper left-hand corner of the window and enter the underlying stock symbol in the symbol box.

5. Click the Options tab.

6. From the strategy box, select Calls.

Focusing on just the monthly options, the only expiration date that falls within your 30 to 60 day window is April 18, 2021, (which is 42 days away). On that date, there is a call option available with a strike price of $82.50, which is fairly close to the $84.00 peak price.

7. Click on the $82.50 contract and select your limit price ($0.56 in example below).

8. Ensure you've selected the appropriate quantity (1 in example below).

9. Enter your preferred timing. In this example, we'll use "GTC" (Good until cancelled).

If you want to change your limit price, you can use the up and down arrows, but for your first trade, consider just entering a limit price that is equal to the bid. Unless the market price moves away from you immediately, this will likely result in an immediate execution, and eliminate the need to wait for the stock price to change in order to get executed.

The trading platform automatically calculates your maximum gain, break even and maximum loss for this sale of one call option. However, because the system does not realize this is a covered call until it executes, these calculations do not include the sale of 100 shares of XYZ if you get assigned. A few things to keep in mind:

• Maximum gain occurs if you get assigned and your stock is called away.
• Maximum loss occurs if XYZ drops to zero, which is very unlikely. Your actual max loss would be -$7,845 (-$7,901 on the stock +$56 on the option).
• The actual breakeven price of 78.45 is below the current market price, so this trade actually provides a small amount of downside protection, which comes from the $0.56 option premium.

10. Select the Sell to Open button.

11. Verify the trade and place the order.

When this order is executed you will have a short call position and receive a credit of $56 (before commissions are deducted). This call will automatically be "paired" as a covered call against 100 shares of your XYZ position. (Typical commission charges for this trade would be $0.65 per contract.)

• Although the premium received from the sale of a covered call provides some downside risk protection, it does not eliminate risk entirely.
• If the price of the underlying stock drops substantially prior to the expiration date, your losses could be significant.
• If your short call goes "in the money," you could be assigned at any time.
• Anytime you sell a covered call, you have established a maximum selling price for your stock. Any movement in the stock beyond that established price creates no additional profit.
• It is rarely a good idea to sell a covered call if your stock position has already moved significantly against you. This could cause you to establish a closing price that ensures a loss.
• While the example above assumes that you hold the position(s) until expiration, you can usually close out a covered call by buying it back at the current market price.
• Watch out for the ex-dividend date. This is the first day following a dividend declaration when a stock buyer is not entitled to the next dividend payment. While stock prices are adjusted for normal quarterly dividends, option prices are not. As a result, when you sell a covered call on a stock that pays dividends, you are at risk of being assigned early if the call goes in the money.

While options trading can be complex, it doesn't have to be intimidating. For many traders, options can provide an effective way to generate modest amounts of income or try to hedge against market and portfolio risk.